GOVERNANCE & RISK MANAGEMENT ISSUES

PRASANNA SESHACHELLAM
23 April 2012

Global Regulatory Standards
Basel II Capital adequacy framework - 2006
Supplemented by revisions in Basel 2.5 - 2009
Basel III – December 2010
IFSB Capital adequacy standard for IFIs (IFSB -2) – Dec 2005
IFSB Capital adequacy standard on securitisations (IFSB-7) – Jan 2009

Global Regulatory Standards
IFSB-7 deals with regulatory requirements for sukuks not covered in IFSB-2
Two main instances:
Sukūks where the holder’s have not assumed all rights and obligations attaching to the underlying assets or pools of assets.
For IFIs where it is the originator of a sukūk issue, or as an issuer or servicer of a sukūk issuance – that is, securitisation exposures.
IFSB-7 specifies:
Conditions for achieving risk transference in securitisation exposures.
Capital treatment of securitisation exposures by IFIs.

Applicability of IFSB Standards
 
IFSB-7 applies to
”Asset-based” and
“Pass-through Asset-based” structures
IFSB-7 applies to both originating and issuing IFIs
Includes instances where the an IFI invests in sukuk it originates.
IFSB-2 covered Asset-backed Sukuk structures
IFSB-2 also covered market risk capital requirement for Sukūk that trade in the secondary market.

Islamic Securitisations–Asset-backed
Involve ownership rights in the underlying assets
Exclude all types of receivables or debts save wherein the same are constituted in a portfolio to the extent permitted under Sharia.
Exceptions where they form a minority part of a pool of assets
Expose Sukūk holders to any losses due to impairment of the assets
Applicable risks are those of the underlying assets.
This category is explicitly covered by IFSB-2

Islamic Securitisations–Asset-backed
Legal obstacles in setting up an appropriate SPE- to meet the conditions for desired fiduciary standard and bankruptcy remoteness
May prevent effective transfer of title in the assets to the investors
Investors may not be able to exercise their rights (for example, to repossess ijārah assets) in case of default
In such cases, it is not feasible to create a structure for issuing non-recourse asset-backed securities (ABS)
Alternatively, if the law permits, IFIs may retain the ownership title of the assets

Collateral security structure
Subject to Sharī`ah permissibility, in respect of perfectibility
Security must be of first priority and perfected
Needs a legal opinion, which must address
the nature of the security interest,
the enforceability of the security interest against third parties, and
perfection requirements
 

Collateral security – Legal review
Legal review of the effects of bankruptcy on perfection
Relevant issues include:
Rahn - in certain jurisdictions are possessory in nature, which makes it difficult to perfect collateral interest in these jurisdictions
In many jurisdictions, perfection and priority regimes are not well developed
Bankruptcy laws and regimes may also not be well developed in some jurisdictions

Asset-based Structures
Pay-through & Pass-through structures
Issuing entity, an SPE, requires the originator to give the Sukuk holders recourse
But also provides Sharī`ah-compliant credit enhancement by guaranteeing repayment
Issuer is a SPE, which should be “bankruptcy remote”
Potential legal obstacles to setting up an appropriate type of SPE
For Sukūk holders, capital requirements are based on originator’s risk weight, subject to any Sharī`ah- compliant credit enhancement by the issuer

Pay-through Structures
Originator enters into a repurchase undertaking (binding promise)
Often used in ijārah (sale and leaseback) Sukūks
Usually employed in legal environments where ownership rights may not give effective right of possession in case of default
The applicable credit risk is that of the originator, subject to any Sharī`ah-compliant credit enhancement by the issuer
Consequently, the Sukūk holders need to have a right of recourse to the originator in case of default
Risk analysis of underlying assets becomes secondary

Pay-through Structures
Relevant risks:
the enforceability or strength of the repurchase undertaking in the jurisdiction, and
the ranking or priority of the sukūk in the capital structure of the originator
A Mushārakah structure may be used that replicates asset ownership by setting up a venture (mushārakah) jointly owned by the Sukūk issuer (usually incorporated as a SPE) and the originator

Pass-through Structures
Asset-based Sukūk where a separate entity may act as sponsor and issuer
Sponsoring entity requires the originator to give the holders recourse
But provides Sharī`ah-compliant credit enhancement by guaranteeing repayment in case of default by the originator

Risk Exposure of Originator
Risks related to repurchase undertaking (binding promise)
Obligated to make payments in respect of the Sukūk or the assets, if there is a breach of certain representations or warranties
May need to compensate the issuer in the equivalent amount or replace the relevant assets

Risk Exposure of Servicer
Service default risk
Dependence on the originator, where underlying assets are consumer linked
Originator usually maintains the business “relationship”
Continues to collect payments on behalf of the sukuk holders
A default of a servicer would still have an adverse effect on performance of Sukūk

Risk Exposure of Issuer
Default Risk
Failure to make coupon payments, the Sukūk holders can declare an event of default and
Accelerate payment obligation of the originator
Can force the originator to repurchase the asset
Failure to pay the payable amounts (including face amount) at maturity - Sukūk holders have a right to take legal action
The Sukūk holders also have the right to sell or foreclose on the underlying assets

Risk Exposure of SPE
Bankruptcy risk: generally incorporated as a bankruptcy remote vehicle
Settlement risk: To avoid any settlement risk, all payments due from the obligor can be arranged to be paid directly to the clearinghouse
Clearinghouse will then settle the payments directly to Sukūk holders

Risk Exposure of Sukuk Holder
Liquidity Risk: Market liquidity risk associated with either the primary or secondary market
Rate of return risk: If the underlying rentals are fixed, then IFIs holding the Sukūk will be exposed to rate of return risk
Issuer may exercise a clean- up call, and the holders of the Sukūk being cancelled may not get the expected return
Impairment of assets: Depending on the structure, the holders of Sukūk bear any losses in case of the impairment of the underlying assets

Operational Requirements – Securitised Assets
Shari`ah compliance of assets in the securitisation
Securitised assets may include Ijārah assets, Murābahah or Salam receivables, Istisnā` assets or equity ownership (Mushārakah or Muaārabah)
Sukūk may also be based on a portfolio of underlying assets comprising different categories
Use of a portfolio allows combination of tradable and non-tradable assets, up to a limit
Ventures organised as Mushārakah or Muaārabah partnerships may be securitised
Where such Sukūk are held by an IFI until maturity and are unrated, they can be treated under provisions for “equity position risk in the banking book”

Recognition of Risk Transference
IFI may exclude securitised exposures from calculation of its capital charges only if all of the following conditions are met
Substantially all credit and price risks associated with the securitised assets have been transferred to third parties
Originator does not maintain effective or indirect control over the transferred assets
The assets are legally isolated from Originator
The securitised assets are bankruptcy remote from Originator
To be Sharī`ah-Compliant, the structure must transfer all ownership rights in the assets from the originator via the issuer to the investors
Compliance with these criteria is confirmed by a legal opinion

Recognition of Risk Transference
Sukūk investors have no claim against the originator
Hence, assets in asset-based structures (pay-through and pass-through structures), would not qualify for derecognition
Originator transfers the assets to a SPE, and the holders of the interests in that entity have the right to pledge or exchange such interests without restriction
Clean-up calls must be at the discretion of the originator
Must not be structured to provide credit enhancement
Must be exercisable only when 10% or less of the purchase consideration for the underlying assets remains to be paid
An IFI meeting these conditions must still hold regulatory capital against any exposures arising on account of any credit enhancements it provides

Transfer of Ownership / Rights
Depending on the legal system, ownership does not necessarily include registered title
Transfer could be a simple collection of ownership attributes that allow the investor:
to step into the shoes of the originator; and
to perform (perhaps via a servicer) duties related to ownership.
For regulatory purposes, derecognition of assets from the originator’s balance sheet relies on a “true sale”
The question of whether legal isolation has been achieved is to be judged by best practice standards

Shari’ah Requirements for True Sale
The transfer must be such that it cannot be recharacterised by a court or other body as a secured loan
Transfer should not be open to inclusion by court in insolvency proceeding of the originator
The bankruptcy or insolvency of the originator should not affect the assets that have been transferred to the issuer / SPE
The transfer must be perfectible at the choice of the issuer
The sale must be free and clear of all prior overriding liens

Treatment for Regulatory Capital
Key issue for IFI - extent to which underlying assets have been transferred to the Sukūk holders
In Islamic securitisation - exposures to other risks in addition to credit risk – in certain asset categories
Consideration of risks other than credit risk, such as price risk – especially where the underlying asset is a Salam or Istisnā` asset
Tradability of Sukūk is often a key issue, for an IFI acting as a sponsor
But, it is unrelated to the capital treatment of the underlying assets by the originator

Capital Charges for Originator
Capital for exposures of an IFI where it is the originator – IFSB-2
IFSB 2 prescribes the credit risk weights (based on Basel II) for the retained securitisation exposures
Originators are required to hold capital for all of their Retained securitisation exposures -
Including those from provision of credit risk mitigants to a securitisation
investments in ABS originated by them, and
extension of a liquidity facility or credit enhancement
Repurchased securitisation exposures must be treated as retained securitisation exposures
Capital Charges calculated by applicable prudential rules

Implicit Support
Originator providing implicit support to a securitisation, must, at a minimum, hold capital against all of the exposures associated with the securitisation as if they had not been securitised
Existence of implicit support restricts the derecognition of securitised assets
Implicit support could not be met out of IAH funds without the consent of the IAH
Implicit support must be Sharī`ah-compliant
If not, the IFI is required to disclose publicly including capital impact of the support

Treatment of Liquidity Facilities
Liquidity facilities must be Sharī`ah Compliant
Must meet operational requirements specified by the regulator, for eligibility of a Sukūk liquidity facility
Facility documentation to identify clearly and limit the circumstances under which it may be drawn
20% CCF - for facilities with maturity of less than one year
50% CCF - for facilities with maturities exceeding one year
A servicer cash advance must be separate from the Sukūk undertaking for Shari’ah compliance
This separation be properly documented
Regulator has discretion to assign a risk weight of 0% to such facilities

Credit Risk Mitigation for Securitisation Exposures
Applies to an IFI that has obtained a credit risk mitigant to a securitisation exposure
Credit risk mitigants include guarantees, collateral and on-balance sheet netting
IFSB 2 recognises any other Sharī`ah-compliant credit risk mitigation allowed by the regulator
Eligible collateral is limited to that recognised under the standardised approach for CRM
Collateral pledged by SPEs may be recognised

Credit Enhancement from an Issuer or Originator
For Sukūk with credit enhancement provided by the issuer or the originator, credit risk weight is based on the credit rating of the credit enhancer
Subject to Sharī`ah approval of the structure, an originator may retain a small equity share in a pool of securitised assets in order to provide over-collateralisation
Any shortfall in the share of income to the Sukūk holders would be compensated by the share of income owing to originator’s first loss position based on a Hibah (donation) agreement
Capital treatment of the originator’s residual equity share would be either a deduction from its capital or a risk weighting of 1250%

Credit Enhancement from the Structure
In a Sharī`ah-compliant credit enhancement structure, different components in the structure need to be risk-weighted, as set out in Basel II
When an IFI is required to deduct a securitisation exposure from its capital, the deduction must be taken 50% from Tier 1 and 50% from Tier 2
Deductions from capital may be calculated net of any specific provisions taken against the relevant securitisation exposures

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